Spring this year brought a lot more than April showers and May flowers! U.S. stocks built on their strong first quarter surge with a very respectable advance in the second quarter. This was no easy task considering the challenging investing environment, outsized market performance contribution from a relatively small stable of growth stocks, and our focus on valuation discipline. And much patience and “intestinal fortitude” was required, as the market hit all-time highs only to be met by a violent 7% thumping with a subsequent bounce back to the high-water marks.
The elevated volatility was hardly surprising considering threats of a trade war (and actual war!) on multiple fronts, the deterioration in almost all manufacturing data, rapidly shifting expectations for Federal Reserve action (a 180 degree turn from just six months earlier), and a sharp ramp in posturing by both parties ahead of next year’s elections. The market action reinforced two reliable truisms: that, although often conflated, volatility and risk are not the same thing and outcomes relative to expectations often move markets more, at least in the short-intermediate term, than outcomes in an absolute sense. Volatility represents the price of admission, the stomach ache we often have to put up with to earn returns above what money markets and treasuries offer. True risk refers to either permanent loss of capital or the likelihood of failing to achieve financial goals by being positioned too conservatively. We need to understand these crucial differences and strike the proper balance between managing risk in the present and remaining on course to achieve the long-term objectives of a well-thought-out financial plan. Markets are vulnerable when an outcome that was considered a foregone conclusion is proven to be off-base or ill-timed. Much of the volatility in the quarter can be traced to the surprising teasing of a tariff fight with Mexico and the unwinding of the consensus assumption that a trade deal would be quickly struck with China.
Investors often achieve less than satisfactory results because they buy into the story du jour, whatever the political and economic prognosticators are selling. How often do most forget that the economy is not the market and the market is not the economy? Record mutual fund outflows last December and then again in May suggest many blindly adopted the narrative at the time, sold at the lows and presumably missed the subsequent bounce backs. An important part of our efforts here is to help filter the salient from the daily noise. We tried to key on the central issues during the quarter – a treacherous global trade environment and expectations for interest rate cuts in face of sluggish economic data – and kept our portfolios exposed to the market upside while still being prudently balanced for potentially increasing risk. Lower interest rates can be a tailwind for economic growth and also leave stock yields that much more attractive relative to bonds, future company cash flows that much more valuable when discounted to the present and higher valuation multiples more palatable. Almost every negative economic data point during the quarter was accompanied by a drop in bond yields, which kept the markets on a mostly upward trajectory. It may prove wise to question whether the Fed should be cutting rates at this point, what the longer term ramifications of a perpetually accommodative monetary environment might be and what such low rates “say” about the health of the global economy, but for now we will manage through the current reality while remaining flexible.
Investors have been hyper-focused on trade issues as rallies and sell-offs during the quarter were highly correlated with perceived progress or disconnects in trade talks. Stock markets internally grew increasing bifurcated between those companies with global trade exposure and those expected to be less impacted. While the direct hit from tariffs on corporate fundamentals is likely limited and quantifiable, the lack of policy visibility has already led to inventory drawdowns and decreases in capital investment, which have the potential to dramatically impact sales throughout the supply chain. These ancillary impacts and concerns that trade uncertainty will delay future corporate spending decisions could tip the scales more negatively. However, along with the support of lower rates, the broad market has been propelled by the fact that the U.S. is still largely a service economy, which remains relatively healthy given low unemployment and gradually rising wages. We will be watching for signs of “contamination” from the more troubled trade-sensitive pockets that would lead us to become incrementally cautious. The degree to which companies pass off higher input costs from tariffs in the form of higher prices or announce job layoffs to counter tighter profit margins needs to be monitored.
With so many variables and little way to predict their shelf lives, we choose to focus more on individual businesses and what to pay for those businesses. There is likely opportunity in the most economically sensitive sectors – Energy, Materials, Financials and Industrials – that underperformed for most of last year and continued for the most part to lag during the second quarter. These companies operate to a large extent at the “epicenter” of the trade conflict – the automobile and semiconductor supply chains. A few companies have been very conservative with their earnings and revenue guidance going forward and have modeled continued disruption in demand from their important customers. The “E” in the “P/E” (price-to-earnings ratio) can still come down, but their multi-year trough valuations already discount the possibility. Their valuations might not yet price a full-blown recession, and we have no way of knowing whether we have caught the bottom. However, the margin of safety provided by their contracted multiples and promising long-run prospects for their businesses should eventually win out even if our timing is off. We are similarly willing to be patient with high-quality financial companies, also trading at relatively subdued valuations, whose well-diversified global business models make them less sensitive to a flat-to-inverted yield curve and trade disruptions than more provincial banks. Relaxing capital constraints are also allowing these stalwarts to rebuild their dividend payouts to very attractive above-market levels.
More broadly, “value” stocks are the cheapest they have ever been relative to “growth” stocks, including what was measured at the very peak of the bubble in 2000. We wonder if clients would stick with us if we advertised that we buy the most expensive stocks and add to them as they go up and grow even more expensive. The answer is probably a resounding “no,” but that is precisely the investment strategy that has worked the best over the past few years. Undoubtedly, there will come a time when more reasonably priced stocks lead, and the outperformance of one style over the other tends to run in multi-year cycles that can shift at any time. Any signs of stabilization in some of the hardest hit, cheaper sectors would give us confidence that the downside economic risks have been largely priced in, an inflection point might be at hand and that it is time to increase our weighting.
In the meantime, we did trim some of the holdings most sensitive to a downturn in the global economy. This includes much of our positioning in Europe – a market that although cheap has much more sensitivity to the China economy and is navigating the messy fallout from Brexit. This extra liquidity generated serves as an additional risk buffer and some “dry powder” to take advantage of opportunities, particularly in companies that still do have visibility into solid earnings trends even in a challenging environment.
Bonds always seem to get second billing in our commentaries, but their resurgence this year has helped to both reduce portfolio volatility and complement total return. Last year was a rarity in that stocks and bonds declined together for the first time in several decades. In fact, with almost every asset class declining except cash, some went so far as to question the merits of diversification in general. As rates fall, fixed-income prices generally rise, and through the end of the second quarter bonds have produced some of their best returns in years. Of course, for portfolios mostly invested in individual bonds, we are largely referring to “paper” gains and losses here. As long as the bonds remain solvent and are held to maturity, we have a high degree of visibility into positive returns regardless of what the rate environment looks like in the interim. If interest rates stay relatively low, fixed-income holdings should continue to ballast portfolios amidst the volatility in the stock market.
As always, we remain vigilant in monitoring the risks of our client portfolios and the overall market. We will continue to own well-managed companies and advantaged business models and are positioned to capitalize should volatility create the opportunity to acquire companies we covet at reasonable valuations. We are always amused when we hear the clichés, “the easy money has been made” or the “markets don’t like uncertainty.” Markets are never easy or certain! We will do our best to steer our clients through and keep them on track to meet, and hopefully exceed, their long-term goals and objectives. We appreciate your continued trust and confidence and wish you and your family all the best for a wonderful summer!